Post-COVID Recovery, Supply Chains and Prices
Under the dramatic heading that The World Economy Is Suddenly Running Low on Everything, a recent article by Bloomberg Businessweek argued that ‘surging corporate demand is upending global supply chains’ leading to shortages of basic commodities and consumer goods, and price increases.
The evidence that was marshalled to support these conclusions is pretty convincing. Indeed, as discussed below, the impact on prices and on longer term inflation may be even greater than was suggested.
However, while recovery from the COVID-induced slowdown and constraints within supply chains are important in the short term, and may be seen as triggers for longer lasting impacts, there are other important factors also at play.
Recovery and Supply Chain Constraints
As has been well documented, the COVID lock-downs led to sharp falls in sales, transport volumes and inventories. These impacts fed along the supply chains and affected not just finished products but the volumes of basic commodities and other inputs that were being held in stock.
As demand now recovers, constraints have emerged in supply chains, even where these were not dismantled during the slowdown or where they can be reinstated quickly.
The problem is not just a recovery to pre-COVID levels of demand, or the sped of the adjustment. After all, consumer demand remains suppressed in many parts of the economy. Rather, the problem is that what economists would describe as a ‘disequilibrium’ situation has arisen.
In a normally functioning market, when supply becomes tight or demand surges, prices rise. This rise causes demand to ease and provides an incentive for producers to place increased supply onto the market. This rebalancing brings prices back to their trend level and the market forces back towards equilibrium.
But what if producers fo consumer products see that prices of basic material inputs are likely to rise further as a result of constraints that will take time to address? In such a circumstance, the incentive is not to reduce demand but to try to stockpile to avoid higher future prices and to avoid running short.
The result: prices are pushed up further, the constraints become more harmful, and the adverse cycle repeats.
These constraints are now being felt in bulk transport, shipping and trucking. Recent headline events such as the Suez Canal blockage, cyber attacks on supply lines, and some adverse weather conditions have made the effects, and perceptions of the extent of the problems, even worse.
The US Logistics Managers’ Index, which reflects the views of logistics managers on future trends in the costs of inventory, transport and warehouse, recorded a reading of 74.5 in April 2021, the second highest reading since its inception. Anything above 50 indicates expectations of increasing costs.
The clear incentive given this background is to seek to increase inventories in order to avoid higher future expenses. In this respect, the activity reflects the decisions of market speculators who buy securities when their prices rise in the expectation that the rise will continue. It’s also a bit like the thinking that propelled the Irish property market before 2008.
Commodity Prices
Financial markets are, by their nature, forward looking. The focus is not on where prices are today – which is really a quite meaningless number when looked at in isolation – but where they are relative to where they will be in the future.
Of course, this is the great unknown: nobody knows what level a market price will be at in the future and to suggest any price that differs from the price today is an argument that you know more than the market in aggregate. That’s a lonely, if sometimes profitable, place to stand.
To address this, investors look at where prices have been in past, in other words, how they got to where they are today. They then try to decide if there is reason to expect that the trend that got them to where they are today is likely to continue, or to reverse.
Recovery from the slowdown has caused a short increase in activity. This is reflected in measures such as Baltic Dry Index. Even a quick glance shows an uptrend that has actually been in place since 2016 with a sharp reversal in 2020 and a very sharp move up in 2021.
There are numerous commodity indices available but all show similar trends. Prices eased up to 2016 and then stabilised before falling back in early 2020. Since this there has been a sharp increase. Again this shows no signs of stabilising.
We know where markets that are based on forces such as this can go. The end is seldom pretty and usually harmful. But a more important question may be how long this can continue and how far prices can go. Is this a temporary aberration that will ease or reverse when the supply chain issues have been sorted?
Indications from Financial Markets
Any answer to this question is probabilistic at best, but there are two indications that suggest that the effects will be longer lasting and the current events – the COVID recovery and the supply chain constraints – might be better seen as triggers rather than fundamental causes of longer term developments.
The first argument relies on a more detailed interpretation of what has been seen in financial markets, particularly commodity markets. As is pointed out in this investment newsletter, this requires that only the actions of traders known as ‘Commercials’ should be examined.
Commercials are those traders who are experts in particular commodity markets and who examine the fundamentals of supply and demand deeply and use this information to hedge against price movements in holding of real products. In this they differ from speculators who primarily study what is happening in the market often with limited regard for the nature of the underlying product.
Commercials have been showing unusual behaviour in many markets in recent times. Because they are primarily hedging, it is to be expected that Commercial will hold ‘long’ positions when they are bearish about prices, that is, when they expect prices for the underlying product to fall. This seems counterintuitive but their primarily objective is to reduce the risk profile of the companies who hold large stocks of the underlying commodity, not to just make a trading profit.
However, when the chart of the copper market below is examined, it shows that commercials have been building and holding long positions while being bullish. The only explanation is that they have a strong expectation that prices will rise for a protracted period.
Similar developments can be seen in other markets also.
Macroeconomic Policy and Money
The second argument relies on a review of macroeconomic policy and developments, in particular, interest rates.
The world has experienced an unprecedented period of extremely low interest rates stretching back to just after the financial crisis of 2008. While this has come to be seen as the norm and that even a very modest increase in interest rates would be a dramatic change, it is far from the historical norm.
The arguments for low interest rates were well founded in the aftermath of the 2008 crisis and played a large role in continuing that crisis and in the subsequent recovery. However, the arguments for the continuation of rates at such low levels are little more than there has not seemed to be an urgent economics reason to raise them, and plenty of political reasoning to keep them low.
However, it is important to understand that low interest rates imply loose monetary policies, in other words, central banks allowing the money supply to increase at will. The effects of this approach can be seen in money supply data for the major economies.
The chart below shows the growth in M1 in the United States – one of many measures of the money supply – from 1990 to 2018. It shows gradual growth initially that accelerated after 2008.
Now look at what happened in 2020. The impact fop the financial crises almost disappears when compared with the impact of the reaction COVID.
This is an extraordinary development. Other measures of the money supply and charts for other currencies show broadly similar – if less dramatic – trends.
Money Supply and Prices
In itself, this means little other than indicating what we already know: that the past years or so has been way out of the ordinary and that Governments have taken unprecedented measures in reaction to COVID.
But, it has long been known that big changes in the money supply in excess of economic growth rates will eventually affect the value of currency. Another way of saying this is that they will facilitate rising prices and I have previously written on the inevitability of inflation. The unknown is when these effects might appear.
But, the money supply has been rising quickly for over a decade and inflation has remained low. Various explanations have been pout forward for this.
Some of these can be classed as ‘real world effects’. These include
- Technology – we can produce more output from less inputs so no price pressure
- New resources – cheap labour from China and Asia
- Globalisation leading to greater efficiency
- Geopolitics – the price of oil was being kept low
- Fear, uncertainly and risk aversion
Most of these explanations are still relevant, although oil has risen back to the levels of a few years ago and global trade has been hit. So why would prices now seem to be rising? Is it just a reaction to supply chains constraints?
The monetary evidence suggests that this is certainly relevant in the short term but that there is a real risk that it may eb just a trigger for longer term effects.
So far, policy makers have not reacted to this threat with the danger of choking off the post COVID recovery being seen as too important. However, given the economic background, the results of policy over the past decade or so, and recent developments, there is a very fine line being walked and the danger of inflation escaping from the control of policy is very real.
We may look back on this period of recovery as a period during which a trigger was pulled, the effect of which could be with us for many years.
Kevin Hannigan has worked as an economic consultant based in Ireland for the past 25 years and lectures on economics at various institutes including the Irish Management Institute. He has undertaken economic research in a wide range of areas with an emphasis on policy evaluation and appraisal. He has a broad knowledge of the Irish and European economies and a deep appreciation of the importance of the economic context for the formation of business projections, the evaluation of alternatives and the outcomes of decisions.
